Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. As with many other companies Encompass Health Corporation (NYSE:EHC) makes use of debt. But is this debt a concern to shareholders?
When Is Debt A Problem?
Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.
What Is Encompass Health's Net Debt?
As you can see below, Encompass Health had US$2.90b of debt, at March 2021, which is about the same as the year before. You can click the chart for greater detail. However, because it has a cash reserve of US$223.9m, its net debt is less, at about US$2.67b.
How Strong Is Encompass Health's Balance Sheet?
We can see from the most recent balance sheet that Encompass Health had liabilities of US$812.2m falling due within a year, and liabilities of US$3.66b due beyond that. Offsetting these obligations, it had cash of US$223.9m as well as receivables valued at US$633.6m due within 12 months. So its liabilities total US$3.61b more than the combination of its cash and short-term receivables.
This deficit isn't so bad because Encompass Health is worth US$8.63b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.
We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Encompass Health has a debt to EBITDA ratio of 2.9 and its EBIT covered its interest expense 3.7 times. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. More concerning, Encompass Health saw its EBIT drop by 2.3% in the last twelve months. If that earnings trend continues the company will face an uphill battle to pay off its debt. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Encompass Health can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we always check how much of that EBIT is translated into free cash flow. Looking at the most recent three years, Encompass Health recorded free cash flow of 44% of its EBIT, which is weaker than we'd expect. That's not great, when it comes to paying down debt.
Both Encompass Health's interest cover and its net debt to EBITDA were discouraging. At least its conversion of EBIT to free cash flow gives us reason to be optimistic. We should also note that Healthcare industry companies like Encompass Health commonly do use debt without problems. We think that Encompass Health's debt does make it a bit risky, after considering the aforementioned data points together. Not all risk is bad, as it can boost share price returns if it pays off, but this debt risk is worth keeping in mind. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. Be aware that Encompass Health is showing 3 warning signs in our investment analysis , you should know about...
At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.
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